9 CHAPTER D YNAMIC P OWER P OINT ™ S LIDES BY S OLINA L INDAHL Saving, Investment, and the...

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DYNAMIC POWERPOINT™ SLIDES BY SOLINA LINDAHL

Saving, Investment,Saving, Investment,and the Financial and the Financial

SystemSystem

CHAPTER OUTLINE

The Supply of Savings

The Demand to Borrow

Equilibrium in the Market for Loanable Funds

The Role of Intermediaries: Banks, Bonds, and Stock Markets

What Happens When Intermediation Fails?

The Financial Crisis of 2007–2008: Leverage, Securitization, and Shadow Banking

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To Try it! To Try it! questionsquestions

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Some good blogs and other sites to get the juices flowing:

Food for Food for Thought….Thought….

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In this chapter we learn how the loanable funds market: brings savers and borrowers

together to make both better off.

gathers savings and allocates it to the most profitable investments.

promotes economic growth.

Introduction

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Saving:Saving: income that is not spent on consumption goods.

Investment:Investment: purchase of new capital goods.

Caution: “Investment” is defined differently by economists than by stockbrokers.

Important Definitions

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What Determines the Supply of Savings?

1. Smoothing consumption2. Impatience3. Market and psychological

factors4. Interest rates


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1. Individuals Want to Smooth Consumption

Save during working years to provide for retirement.

Savings rises as life expectancy rises (or retirement age drops)

Manage fluctuations in income.Save during good times in order to ride out the bad times.


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Savings Help Smooth Consumption

Path A: consumption = income, Path B: By saving during workingyears, consumption can be smoothed.

IncomeConsumption

Time

Path A

Working Years Retirement

Saving

Dissaving

Path B

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2. Individuals Are Impatient

Time preferenceTime preference: the desire to have goods and services sooner rather than later.

Anything with immediate costs and future benefits must overcome time preference.

• College education

People who discount future consumption more will save less now.


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Professor Philip Zimbardo (of the famous Stanford prison experiment) conveys how our individual perspectives of time affect our work, health and well-being with the animation expertise at RSA Animate. Time influences who we are as a person, how we view relationships and how we act in the world. (10:09 minutes)

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3.Marketing and Psychological FactorsThe way choices are presented makes a

difference.Example 1: Retirement savings plans

Result: Participation in the savings plan was 25% higher for companies with automatic enrollment.


Will he give his 401K much thought? Not necessarily.

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4. The Interest Rate

Interest is the reward for savings.

It’s the “price” of savings.

The higher the interest rate, the greater the quantity saved.


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Savings(billions of dollars)

Interest

rateSupply

of savings

$200 $280

10%

5%

The higher the interestrate, the greater the amount of savings.


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What determines the demand for borrowing?

1.Smoothing consumption

2.Financing large investments

3.The interest rate


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1.Smoothing Consumption

Lifecycle Theory of Saving

Nobel laureate Franco Modigliani:

By borrowing, saving, and dissaving at different times in life, workers can smooth their consumption path, improving their overall satisfaction.

Governments also smooth consumption for wars, deficits, etc.


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IncomeConsumption

Time

ConsumptionPath

College, buying first home

Prime workingyears

Retirement

Saving

DissavingBorrowing

By borrowing, saving, and dissaving,workers can smooth their consumption.

Income Path


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2. Borrowing Is Necessary to Finance Large Investments

Without the ability to borrow many profitable investments will not happen.

Example: Fred Smith and FedEx

Many ventures cannot “start small.”


Needed: start-up funds

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3. The Interest Rate

Determines the cost of the loan.

An investment will be profitable only if its rate of return is greater than the interest rate.

The higher the interest rate, the smaller the quantity demanded of savings will be:

because there are fewer investments that “make the cut” of yielding a higher return than it costs to borrow the funds to finance the project.


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Savings(billions of dollars)

Interestrate

Demandto borrow

$300$190

10%

5%

The higher the interest rate, the lower the demand to borrow.


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The Market for Loanable Funds:The Market for Loanable Funds:

Is where suppliers of loanable funds (savers) trade with demanders of loanable funds (borrowers).


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Savings/borrowing(in billions of dollars)

Interestrate

Supply

$200 $280

10%

5%

Demand

$300$190

8%

$250

Equilibriuminterestrate

Equilibrium quantityof savings/borrowing

Surplus → ↓ i

Shortage → ↑ i


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Shifts in Supply and Demand

If Supply or Demand shifts, the equilibrium interest rate, quantity of savings and investment will change.

Examples:

The stock market crashes: household wealth drops → people save more to restore their wealth.

The economy goes into a recession and investors become more pessimistic.


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If Supply or Demand shifts, the equilibrium interest rate, quantity of savings and invest.

If the stock market crashes, people save more to restore their wealth.

Savings/borrowing (in billions of dollars)

Interestrate Old Supply

5%

Demand

$300

8%

$250

New supply

Results: 1.Lower equilibrium interest rate2.Greater savings/borrowing


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If investors become more pessimistic during a recession, they reduce their borrowing.


Interestrate Supply

$200

5%

Old Demand

8%

$250

New demand

Result: 1.Lower equilibrium interest rate2.Lower savings/borrowing


Try it!Try it!

If the government gives a tax credit on investment, then which of the following is TRUE about the loanable funds market?a)The demand for loanable funds will increase, and the interest rate will also increase.b)The demand for loanable funds will decrease, and the interest rate will decrease.c)The supply of loanable funds will decrease, and the interest rate will increase.

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Try it!Try it!If savers don't feel safe putting their money in banks or buying bonds, what's the best way to sum up what's happening in the market for loanable funds?a)Supply of savings falls and the interest rate falls.b)Supply of savings falls and the interest rate rises.c)Demand for savings falls and the interest rate falls.d)Demand for savings falls and the interest rate rises. To next To next

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Financial InstitutionsFinancial Institutions reduce the costs of moving savings from savers to borrowers and investors.Middlemen who help coordinate financial markets.Help move savings to more highly valued uses.

We examine three financial intermediaries:

1.Banks2.Bond markets3.Stock markets


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Banks:Gather savings

Reduce risk by evaluating ability to pay off loans.

Spread risk

When a borrower defaults on a loan, the bank spreads the loss among many depositors.

Coordinate lenders and borrowers.

Minimize information costs.

Conclusion: Banks help gather savings and allocate it to the most productive uses.


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Think-Pair-Share:Besides decreasing the numberof banks, how do bank failureshinder financial intermediation? To next To next

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The Bond MarketA bondbond is a sophisticated IOU that documents who owns how much and when payment must be paid.Issuing bonds allows borrowing directly from the public.

Lender: one who buys a bondBorrower: one who issues a bond

Corporations and governments at all levels borrow money by issuing bonds.

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The Bond Market (cont.)

All bonds involve a risk.Major issues are graded by rating companies:

Standard and Poor’sMoody’s

Grades range from lowest risk (AAA)bonds in current default (D)

The higher the risk the greater the interest rate required to get lenders to buy the bonds.


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Collateral:Collateral: something of value that by agreement becomes the property of the lender if the borrower defaults.

The higher the collateral the lower the risk (and therefore interest rate)

Other elements of interest rate determination:

Repayment timeAmount of loanType of collateralRisk of borrower default

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The Bond Market: Examples

Berkshire Hathaway (Warren Buffett)• Bond rating: AAA• Interest rate: 4.48%

Ford Motor Company• Bond rating: B• Interest rate: 5.76%

Home mortgage rates are lower than vacation loans because mortgage loans are backed by collateral.

Conclusion: the higher the risk the higher will be the rate of return.

Note: lower bond ratings increase the cost of borrowing


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The Bond Market (cont.)

Governments issue bonds to borrow money.

Government borrowing can crowd out private spending.

Crowding-out: Crowding-out: the decrease in private consumption and investment that occurs when government borrows more.

Here’s how crowding-out works:↑Saving ↓consumption↓Investment

↑borrowing→ ↑interest rate →


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Interestrate

Supply

$200

7%

Private demand+$100 billion govt. demand

9%

$250

Private demand

a

bc

$150

Govt. borrows$100 billion


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Different kinds of U.S. bonds:

T-bonds: 30 year maturity, pay interest every 6 months.

T-notes: 2 to 10 year maturity, pay interest every 6 months.

T-bills: mature in 2 days to 26 weeks, pay interest only at maturity.

Bonds that pay interest at maturity are called zero-coupon bonds.

Short-term U.S. government bonds tend to be the safest assets.


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Bond Prices and Interest Rates

A bond can be sold any time before maturity.

Sellers of bonds compete to attract lenders.

Face Value (FV): how much the bond is worth at maturity.

Rate of Return: the implied interest rate (%) the bond earns. 100

PricePrice-FV

bond coupon- zeroa for Return of Rate


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Example: Suppose a low risk bond will pay $1,000 one year from now. If you pay $950 for the bond now, the rate of return on the bond will be:

Unless the market rate of interest is less than 5.26%, no one will buy the bond.

The less paid for the bond, the greater will be the rate of return.

The higher the market rate of interest, the less anyone will pay for the bond.

%.$

$,$ 265100950

9500001


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Suppose you paid $800 for a zero-coupon bond with a face value of $1,000. If you held that bond until maturity, then the rate of return would bea)–20% b)20% c)–25% d)25%


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Takeaways:

1.Equally risky assets must have the same rate of return

If not, there will likely be arbitrage

Arbitrage: Arbitrage: the buying and selling of equally risky assets (to exploit differences in price).

Arbitrage is covered in more detail in the appendix.

2.Interest rates and bond prices move in opposite directions

Changing interest rates will change a bond’s market value.This means that bond buyers face

interest rate risk along with default risk.

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The Stock Market

A stock (or a share) stock (or a share) is a certificate of ownership in a corporation.

Stocks are traded in organized markets called stock exchanges.

New York Stock Exchange (NYSE) is the largest.

Tokyo Stock Exchange (TSE) is the second largest.


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Sales of new shares:

IPO (initial public offering): IPO (initial public offering): the first time a corporation sells stock to the public in order to raise capital

Typically used to buy new capital goods.

Stock markets encourage investment and growth.

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Economic growth suffers.


The bridge between saving and investment breaks down.

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Richard Thaler, (Professor, The University of Chicago Booth School of Business): We Failed to Learn From the Hedge Fund Failures of the Late 90s. His message to overconfident risk managers: there’s more risk out there than you think. (2:02 minutes)

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Insecure Property RightsSome governments fail to protect property rights.

Saved funds can be confiscated, frozen, and otherwise restricted.Result: people are reluctant to put their savings in domestic institutions.

Example: Argentina and BrazilBoth have a history of freezing bank accounts.

Argentines and Brazilians save less.Result: less investment and lower economic growth.


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Controls on Interest Rates and InflationUsury Laws:Usury Laws: create legal ceilings on interest rates.

Result: less saving and investment.

Most American states have usury laws but:

They often have loopholes (e.g., don’t apply to credit cards).

They are set at levels too high to affect most loan markets.


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Savings/borrowing(in billions of dollars)

Interestrate Supply

of savings

$190

ControlledInterest rate

Demand

8%

$300$250

Results:

1.Shortage of savings

2.Less savings/investment

3.Slower economic growth

MarketEquilibrium

Shortage

Effect of Usury Laws


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InflationWhen combined with controls on interest rates, inflation destroys the incentive to save.

Nominal and real interest rates:Nominal interest rate:Nominal interest rate: the named rate; the rate on paper.

Real interest rate:Real interest rate: the rate of return after adjusting for inflation. Therefore:

rate Inflation - rate Nominal rate Real


Try it!Try it!

If the yearly nominal interest rate on a savings account is 5%, and the rate of inflation over the same period of time is 2%, what is the real interest rate?a)5% b)2% c)7% d)3%


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Example: Suppose interest rates are controlled at a nominal rate of 10% and the rate of inflation is 30%. Then:

Result:

Savers are losing 20% a year.

Saving is discouraged.

Less investment and slower economic growth.

20%- 30% - 10% rate Real


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Country YearsReal

Interest Rate (%)

Per capita growth (%)

Argentina 1975-1976 -69 -2.2Bolivia 1982-1984 -75 -5.2Chile 1972-1974 -61 -3.6Ghana 1976-1983 -35 -2.9Peru 1976-1984 -19 -1.4Poland 1981-1982 -33 -8.6Sierra Leone

1984-1987 -44 -1.9

Turkey 1979-1980 -35 -3.1Venezuela 1987-1989 -24 -2.7Zaire 1976-1979 -34 -6.0Zambia 1985-1988 -24 -1.9

Source: Easterly (2002, p. 228)

Negative Interest Rates and Economic Growth

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Politicized Lending and Government Owned Banks

Example: Japan 1990 to 2005.Many banks were bankrupt or propped up by the government (“Zombie banks”).

They were not loaning funds for efficient uses.

Other banks were pressured to lend money to well-connected political allies.

Result: economic growth was zero during this period.


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Bank Failures and PanicsBank Failures and PanicsSystemic problems usually lead to large-scale economic crises.During the Depression, between 1929-1933:

11,000 banks (almost half of U.S. banks) failed.Ripple effects:

Businesses could not get working capital.

Many people lost their life savings, resulting in lower spending.


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Result:

Huge amounts of bad loans on the books of financial institutions.

Banks could not get funds to loan.

The bridge between savers and borrowers collapsed. Click the image below for a video clip.

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The Financial Crisis of 2007–2008

Financial Crisis 2007-2008

Many mortgage loans were bundled and sold as if they had very low risk.

Some were sold on false terms.

Credit rating agencies failed at their job.

People expected housing prices to continue to rise.

Housing prices fell.

Many people defaulted on their mortgages.

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The Financial Crisis of 2007–2008: Leverage, Securitization, and Shadow Banking1. Leverage:

Since everyone assumed real estate values would only climb, both households and banks became much more “leveraged”.

Owner equity Owner equity is the value of the asset minus the debt, E = V − D.The leverage ratio leverage ratio is the ratio of debt to equity, D/E.An insolventinsolvent firm has liabilities that exceed its assets.

The problem? None… unless real estate drops.

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The Financial Crisis of 2007–2008: Leverage, Securitization, and Shadow Banking

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The Financial Crisis of 2007–2008: Leverage, Securitization, and Shadow Banking2. Securitization:

Loans can be bundled together (“securitized”) and then sliced up and sold on the market as financial assets.

This has benefits:Provides safety and liquidity for the

bank selling the securitized mortgagesProvides a path for others to invest in

the American economy

And it has costs:Securitization can hide risk and bad

loans.

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The Financial Crisis of 2007–2008: Leverage, Securitization, and Shadow Banking3. The “Shadow Banking System”

Alternative banks (hedge funds, money markets and investment banks) have grown up in the shadow of traditional commercial banks.

2008: these “Shadow banks” loaned $20 trillion (more than traditional banks)

Shadow banks are not insured by the FDIC, nor are they heavily regulated.

When investors got worried about Lehman Brothers’ solvency, it set off a wider bank panic and government bailouts.

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Inside the Meltdown investigates the causes of the worst economic crisis in 70 years and how the government responded. The film chronicles the inside stories of the Bear Stearns deal, Lehman Brothers' collapse, the propping up of insurance giant AIG and the $700 billion bailout. It also examines what Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke didn't see and couldn't stop. (56 minutes)

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Do you think it’s necessary for the Federal Government (and taxpayers) to bail out banks when they are on the verge of collapse?

a)Yesb)No

9 CHAPTER D YNAMIC P OWER P OINT ™ S LIDES BY S OLINA L INDAHL Saving, Investment, and the...

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